Question

Q.1) Discuss the altemative goals of the firm and explain why finance recommends shareholder value maximization? [25 marks] Q.2) Discuss the reasoning of agency theory recommendations for an independent board structure to enhance Corporate Govemance. Examine the extent to which Agency Theory's recommendations have led to enhance firm performance? (25 Marks]

Answer 1

answer 1)

The shareholder wealth maximization goal states that management should seek to maximize the present value of the expected future returns to the owners (that is, shareholders) of the firm. These returns can take the form of periodic dividend payments or proceeds from the sale of the common stock. Present value is defined as the value today of some future payment or stream of payments, evaluated at an appropriate discount rate. The discount rate takes into account the returns that are available from alternative investment opportunities during a specific (future) time period.

The longer it takes to receive a benefit, such as a cash dividend or price appreciation of the firm’s stock, the lower the value investors place on that benefit. In addition, the greater the risk associated with receiving a future benefit, the lower the value investors place on that benefit. Stock prices, the measure of shareholder wealth, reflect the magnitude, timing, and risk associated with future benefits expected to be received by stockholders.

Shareholder wealth is measured by the market value of the shareholders’ common stock holdings. Market value is defined as the price at which the stock trades in the market place, such as on the New York Stock Exchange. Thus, total shareholder wealth equals the number of shares outstanding times the market price per share.

ADVANTAGES OF MAXIMISING SHAREHOLDERS WEALTH

TIMING AND RISK BENEFITS-

The objective of shareholder wealth maximization has a number of distinct advantages. First, this objective explicitly considers the timing and the risk of the benefits expected to be received from stock ownership. Similarly, managers must consider the elements of timing and risk as they make important financial decisions, such as capital expenditures. In this way, managers can make decisions that will contribute to increasing shareholder wealth.

FINANCIAL DECISION-

Second, it is conceptually possible to determine whether a particular financial decision is consistent with this objective. If a decision made by a firm has the effect of increasing the market price of the firm’s stock, it is a good decision. If it appears that an action will not achieve this result, the action should not be taken (at least not voluntarily).

IMPERSONAL OBJECTIVE-

Third, shareholder wealth maximization is an impersonal objective. Stockholders who object to a firm’s policies are free to sell their shares under more favorable terms (that is, at a higher price) than are available under any other strategy and invest their funds elsewhere. If an investor has a consumption pattern or risk preference that is not accommodated by the investment, financing, and dividend decisions of that firm, the investor will be able to sell his or her shares in that firm at the best price, and purchase shares in companies that more closely meet the investor’s needs.

answer 2)

Coming now to the present day, agency theory, with its emphasis on conformance, suggests that the monitoring role of the board, supported by processes such as external audit and reporting requirements, is likely to reduce problems of management pursuing their own interests or performing poorly .The emphasis is on avoiding performance problems stemming from poor management or inappropriate use of managerial discretion. The theory is underpinned by a belief derived from neoclassical economics that, as both principal and agent are utility maximisers, the latter is not likely to always act in the interest of the former. Agency costs are incurred in acting to minimise the gap between the two sets of interests. Three sources of agency costs: monitoring expenditure, bonding costs (to tie the agent in) and residual loss (the costs of agents' decisions which diverge from those that are in the best interests of principals). These authors also emphasise the generality of the agency problem, both at all levels of management and also across different types of organisations, including non-profit organisations (NPOs), government corporations and co-operatives. This is derived from a view that most organisations (private firms, NPOs, government bodies) serve as a nexus for a set of contracting relationships among individuals.

Agency theory carries with it certain assumptions about human behaviour and, for public sector bodies, certain assumptions that governments make about human behaviour. For health care, the assumption behind agency theory is about the need to rein in the self-serving behaviour of managers and clinicians, as well as the need to mitigate against poorly performing managers, which has also been termed ‘honest incompetence’

Recent critiques of agency theory claim that it downplays the complexity of individual motivations and permutations of organisational life and that it relates to a view about the self-centredness of human behaviour in organisations which is now contested. challenge a core assumption behind agency theory, which is the possibility of complete contracting ex ante for all stakeholders. Without this, and with the probability of incomplete contracting, other theories emerge naturally. In a meta-analysis, Deutsch found little support for agency theory's prediction about the impact of board composition, particularly the proportion of outside directors, on critical decisions, for example around CEO compensation, risk and control, that involve a potential conflict of interest between managers and shareholders. Relating closely as it does to the monitoring and compliance aspect of the board role, which is commonly regarded as a cornerstone of board work, agency theory nevertheless continues to hold sway and dominates the literature about board theories

One possible reason for the continued primacy of agency theory is the development of a modernising behavioural variant. This argues that in some circumstances boards may opt for behaviour-based rather than outcome-based incentive schemes for its executives to achieve alignment and optimal contracting.Behavioural agency theory proposes that the traditional advocacy of incentives based on firm-level outcomes may, particularly in view of the impossibility of complete ex-ante contracting, lead to unintended consequences. Behavioural agency theory proposes that incentive alignment can be achieved through outcome-based contracts, behaviour-based contracts or a combination of the two. Whereas outcome-based contracts link CEO pay to firm-level performance, behaviour-based contracts link pay to the board's direct supervision of CEO behaviour, decisions and actions, which, in turn, are assumed to have a positive, if indirect, influence on firm performance.argue the case for behavioural agency theory to mitigate against the potential weaknesses of outsider directors who may suffer from information asymmetry and who may be excessively influenced by institutional emulation or social identity issues in their approach to the setting and controlling of organisation targets, performance and executive incentives.